Valuations in US markets are at extreme levels. The Nasdaq earnings multiple is in the mid-30s — well above the historic average of about 20 and the five-year average of about 30. This extends to more than just the high-flying tech stocks with Costco, a membership bulk-buying warehouse business in the US, sitting on an earnings multiple of just under 50 while its longer-term average is closer to 20.
Now, sure — an earnings multiple, also known as a p:e (price earnings multiple), is a simple valuation metric. But it includes two important data points — price and earnings.
Using p:e for valuation requires looking at historic data, but future earnings growth is what really matters. Take that 50 p:e from Costco. Earnings over the next three years are expected to grow by about 10%. If that continues, then after a decade of 10% earnings, the p:e would be about 25, assuming no change in the current share price. Not sure if that’s a great deal?
But a high p:e isn’t always a red flag — not if earnings growth is strong
But a high p:e isn’t always a red flag — not if earnings growth is strong. Nvidia* also sits on a p:e of about 50 but with expected earnings growth of about 45% for the next financial year, which, if it plays out, would see the p:e drop into the mid-30s. If the next year’s growth is expected at about 35%, the p:e could fall to 20, assuming no price growth.
Of course, the share price could still move higher, but that would mean even higher valuations or slower p:e downscaling. Either way, you’re still buying expensive — and therefore more risky.
A rule of thumb I like: if future earnings growth is at around the level of the p:e, the valuation is likely fair. Back to Costco, with growth of 10% expected, the share price would need to be about 80% lower for the valuation to be fair.
I also like to check the historic data on a p:e. What’s been the average p:e over the past decade and where does the forward p:e (current price with next year’s expected earnings) sit relative to that? If it’s below the average, then I consider the stock to offer value.
As an example, Shoprite* has seen its share price under pressure, falling from more than R300 late last year to about R270 now. The 10-year average p:e is about 21 and the forward p:e about 18.5, so it’s offering value. Checking in with the experts, the consensus average price target is R312, so they agree on the value story. The risk, of course, is that Shoprite fails to deliver on earnings, faces disruption or generally loses its way.
The point is: valuations do matter. Not on the way up when we’re all loving our rising portfolios. But ultimately, any business growing earnings at about 10% a year but trading on a p:e of 50 is not sustainable — and eventually, the price will reflect that truth.
*The writer holds shares in Shoprite and
Nvidia
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